View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.



May 24,1991

Financial Constraints and Bank Credit
Loan growth at commercial banks slowed
markedly in the second half of 1990 and
remained weak through the first part of this
year. To a large extent, the dropoff in lending is
explained by the responses of banks and their
customers to contracting output, rising unemployment, and plummeting consumer and
business confidence.

a reaction to the underlying health of the

A much more controversial explanation focuses
on the financial condition of commercial banks
and its impact on the availability of credit and on
the performance of the economy. The argument
is that poor loan quality, capital constraints, and
a stricter regulatOiy environment have reduced
the willingness of banks to lend. This has raised

A look at the relationship between loan growth
and loan quality for each of the twelve Federal
Reserve Districts is a useful starting point to
examine the effects of the financial condition
of banks on their lending. Chart 1 plots the
growth in total loans and leases at commercial
banks in 1990 against the overall quality of loans
for banks at the end of 1989. Loan quality is
measured as the ratio of performing loans to total
loans. The loan growth rates and the performing
loan ratios are weighted averages for each District. The chart suggests that bank loan growth
last year was positively related to the quality of

tho rllnr.o.rn th':lt thn t:nhtnninn r'\t rr£').,...I:t LVIIUIrr'\.nrli
U I ' - \0....'..111'--'-.-111 UIUl. 1..11"-.- 1..151 IL\.....l III 15 VI \..-1IC::Ull

the loan portfolios. Other factors, hovvevei,also

tions by banks is more than just a symptom of
a slack economy, and that it could impede the
recovery from the recent economic contraction.

affected loan growth in 1990. In the case of the
Boston District, the extreme weakness in bank
lending probably reflects the severity of the
overall economic problems in the New England
states, which had the country's largest percent
decline in employment last year. In the case of
the San Francisco District, on the other hand,
direct acquisition of thrift institutions by commercial banks helped boost the overall loan figures
for banks in the West.

This Letter examines how the financial condition
of banks has affected their lending. The Letter
also looks into how other credit intermediaries
have adjusted to offset the effects of slower bank
loan growth.

Tighter credit and economic conditions
Surveys on bank lending practices conducted
by the Federal Reserve and regularly reported
on by the financial press indicate that many
commercial banks tightened credit standards
from late 1989 through the beginning of this year.
According to these surveys, the tightening of
credit standards has been more prevalent for
businesses than for households.
Banks give several reasons for adopting a
tougher stance on lending. The primary reasons
are a poor economic outlook and industryspecific problems. These factors normally would
be expected to affect bank lending and so do not
suggest anything unusual. However, the other
reasons banks give for tighter credit standards
are related to banks' own financial condition,
namely, the volume of problem loans and capital
constraints. These considerations do suggest that
the restriction of loans by banks may not be just

Chart 1
Loan Quality vs. Loan Growth
By Federal Reserve District

Loan Growth







" ""

Loan Ouality (8904)

" "0

A more formal test analyzes not only the growth
rates in loans at individual banks in 1990 and
the quality of loan portfolios, but also capital-toasset ratios at the end of 1989 and employment
growth rates in 1990 in each bank's region. The
analysis shows that all three factors-the capitalto-asset ratio, the qual ity of a bank's loan portfolio, and regional employment growth-had a
positive and significant effect on its lending. This
would appear to support the survey evidence that
the financial condition of banks and the condition of the economy affected their lending
It's important to note that the financial condition
of a bank and the economic environment in
which it operates may not be factors that are easy
to isolate. For example, it is likely that regional
differences in economic growth and industryspecific problems prior to 1990 affected both the
quality of a bank's loan portfolio and the bank's
views on the prospects for extending additiohal
credit Still, based on the evidence, we cannot
rule out that there was more to sluggish bank
loan growth last year than just a weak economy.

intermediaries, the combined net flow of funds
from life insurance companies, pension funds,
finance companies, and mutual funds jumped
by about $97 billion in 1990 compared with
1989. The decline in intermediation by depositories also was offset by the acquisition of failed
thrifts' assets by the Resolution Trust Corporation
(RTC)-acquisitions that were funded in large
part by Treasury debt. In effect, through the RTC
the federal government acts as a financial intermediary, replacing federally insured deposits
at thrifts with federally guaranteed Treasury

Chart 2
Net Credit Market Funds
4-Quarter Average

$ Billions





More nondepository intermediation

Some have argued that reduced bank lending
will prolong the recession and stall the recovery.
For example, if firms want to expand, they'll face
problems getting loans from banks to finance
their plans. This is a situation that would seem
to be made even worse by the contraction of the
thrift industry. Overall, financial assets (excluding
Treasury securities) at thrifts fell by almost $120
billion last year.
But the situation may not be all that bleak if we
consider not only bank and thrift lending, but
other means of financial intermediation as well.
Chart 2 shows that net intermediation (excluding
Treasury securities) by banks and thrifts combined was nil in 1990. On the other hand, the
chart also shows that the decline in the net flow
of market funds to the private, nonfinancial sector was much less than the drop-off in bank and
thrift intermediation. In the chart, the net flow of
market funds includes the net issuance of corporate equities and of credit market instruments.
The widening of the gap between the lines in
Chart 2 represents a shift to

nevI channels of

intermediation that help offset the effects of
reduced bank lending. Among nondepository








*Excluaes Treasury securities.

Even with these changes in the channels of
intermediation, credit flows to certain sectors
of the economy were weak. Of particular note is
the commercial real estate and development industry. As Chart 3 illustrates, combined mortgage
flows to commercial and multifamily real estate
last year were low not only relative to recent
years, but also relative to the recession years of
the early 1980s. This contrasts sharply with what
has happened to net funds flowing to home mortgages. The difference may be due in part to the
increasing volume of mortgage credit going
through federally sponsored mortgage pools last
year. These consist of pass-through securities collateralized by home mortgages and guaranteed
by federally sponsored agencies. These secondary market instruments have helped to fiil some
of the gap in home mortgage financing left


the contraction of thrift industry. However, it is
likely that the paltry flow of funds to commercial

and multifamily real estate is due more to the
depressed condition of these sectors, as reflected
in the high vacancy rates in many parts of the
country, than to unusually restrictive supply
constra ints,

Chart 3
Net Mortgage Flows

$ Billions
, 300

• Home

EI Commercial

and Multifamily


~l ~. ~.IJ, I.









I. ~




Adjustments to leverage
In addition to a shift in the channels of intermediation, nonfinancial corporations sharply
curtailed the retirement of equity last year, thus
reducing their demand for debt financing from
banks and other market sources, In 1990 the net
retirement of equity by nonfinancial corporations
totaled about $63 billion, roughly half the value
of net retirements in 1989, Even among noncorporate businesses, owners withdrew far less
equity in 1990 than in 1989, This represented an

increase in the reliance of these businesses on
nonmarket financing, and, thus, is not reflected
in the figures plotted in Chart 2.
These developments, along with the higher
profile of nondepository institutions, should have
helped to mute most of the adverse effects from
the'decline in bank and thrift intermediation on
the economy as a whole. For corporations, for
example, net funds raised in the market (the sum
of net debt and equity) in 1990 was not much
different from the level for 1989. In the case of
households, the drop in net market borrowing
last year was more or less in line with the slower
growth in personal disposable income and
movements in market interest rates.

Survey results and other evidence suggest that
to a large extent sluggish bank loan growth
observed over the past several quarters reflects
a poor overall economic environment as well as
problems specific to particular industries. At the
same time, the financial conditions of commercial banks also appears to have contributed to
tighter credit standards and to slower bank loan
growth. The negative effects of the slower commercial bank growth along with those associated
with the contraction of the thrift industry, however, have been dampened by shifts in intermediation patterns and other adjustments by
Fred Furlong
Research Officer

Opinions expressed·;n this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Judith Goff) or to the author.... Free copies of Federal Reserve
publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702,
San Francisco 94120. Phone (415) 974-2246.

Research Department

Federal Reserve
Bank of
San Francisco
P.O. Box 7702
San Francisco, CA 94120